Islamic banks better poised to absorb external shocks: IMF

ISLAMABAD (November 27 2002) : Owing to the structure of their balance sheet and the use of profit-and-loss-sharing arrangement, Islamic banks are better poised than conventional banks to absorb external shocks.

In the event of operational losses, unlike conventional banks, Islamic banks have the ability to reduce the nominal value of investment deposits, that is, reduce the nominal value of a portion of their liabilities. As a result, solvency risks that may arise from an asset-liability mismatch are typically lower in Islamic banks than in conventional banks.

It has been observed in the International Monetary Fund working paper report namely, `Islamic Financial Institutions and Products in the Global Financial Systems; Key Issues in Risk Management and Challenges Ahead.' The paper was prepared to assess the mode of adopting Islamic financial institutions.

Islamic banks operating according to the two-window model (a typical case of “narrow bank,” which is very rare in practice) are virtually insolvency-proof.

Islamic banks operating according to the Two-Tier Mudaraba model (the norm in practice) are still subject to the risk of an asset-liability mismatch because: (1) demand deposits are guaranteed in capital value and are redeemable by depositors at par and no demand; (2) demand deposits can be used to finance longer-term risk bearing investment projects; and (3) there is no mandated specific reserves requirements on demand and investment deposits (vis-à-vis the 100% and zero percent reserves requirements on demand and investment deposits, respectively, mandated in the two-Window model).

Islamic banks show an operational similarity with conventional investment companies, including mutual funds owing to the fact that they do not guarantee either the capital value of or the return on investment deposits and that they basically pool depositors' funds to provide depositors with professional investment management.

There is, however, a fundamental conceptual difference between the two that also needs to be recognised. It lies in the fact that investment companies sell their capital to the public, while Islamic banks deposits from the public.

This implies that shareholders of an investment company own a proportionate part of the company's equity and are entitled to a number of rights, including receiving regular flow of information on development of the company's business and exerting voting corresponding to their shares on important matters, such as changes in investment policy. Hence, they are in a position to take informed investment decisions, monitor the company's performance, and influence strategic decisions.

By contrast, (investment) depositors in an Islamic bank are only entitled to share the bank's net profit (or loss) according to the PLS ratio stipulated in their contracts. Investment deposits can not be withdrawn at any time, but only on maturity and, in the best case, at par value. Moreover, depositors have no voting rights because they do not own any portion of the bank's equity capital.

Hence, they cannot influence the bank's investment policy. In fact, their relationship with the bank is regulated according to an unrestricted Mudaraba contract, as noted previously.

In the Two-Tier Mudaraba Model, the assets and liabilities sides of a bank's balance sheet are fully integrated. In the liabilities side, depositors enter into an unrestricted Mudaraba contract (a trustee finance contract) with the bank to share the overall profits accruing to the bank's business.

Thus depositors act as financiers by providing funds, and the bank acts as an entrepreneur by accepting them. On the asset side, the bank, in turn, enters into restricted Modaraba contracts with agent-entrepreneurs who search for funds to invest and who agree to share profits with the banks according to a certain percentage stipulated in the contract.

In addition to the investment deposits, banks are allowed to accept demand deposits that yield no return and may be subject to a service charge. These deposits are repayable on demand at par value. Depositors, however, are aware that banks will use demand deposits for financing risk-bearing projects. Banks may also grant short-term interest-free loans up to a certain fraction of total demand deposits. Although the concept of reserve requirement is a recognised one in Islamic banking, the Two-Tier Mudaraba model does not mandate specific reserve requirement on either type of deposits.

In the Two-Window Model, bank's liabilities are divided into two windows: one of demand deposits and the other for investment deposits. The choice of the window is left to depositor and the other for investment deposits. The choice of the window is left to depositors. Demand deposit are assumed to be Amanat (for safekeeping), thus they are considered to belong to depositors at all times.

They can not, therefore be used by banks as the basis to create money through fractional reserves.

Consequently, banks operating according to this model must supply a 100 percent reserve requirement on demand deposits. By contrast, investment deposits are used to finance risk-bearing investment projects with depositor's full awareness. Therefore, these deposits not only are non-guaranteed by the bank, but also not reserve requirement is applied to them.

The bank may charge a service fee for its safekeeping services. Interest-free loans may only to be granted from funds specifically deposited for that purpose.

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